1. Chapter 16 Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Payout Policy

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 2 Topics Covered  How Companies Pay Cash to Shareholders  Dividend Payments  Stock Repurchases  How Do Companies Decide on The Payout?  Why Payout Policy Should Not Matter  Why Dividends May Increase Firm Value  Why Dividends May Reduce Firm Value

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 3 Dividend Payments Record Date - Person who owns stock on this date received the dividend. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Cash Dividend - Payment of cash by the firm to its shareholders.

4. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 4 Dividend Payments Stock Repurchase - Firm buys back stock from its shareholders. Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Splits - Issue of additional shares to firm’s stockholders.

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 5 Dividend & Stock Repurchases $ Billions U.S. Data 1980 - 2003

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 6 Dividend Payments Jan 13 Feb 2 Feb 3Feb 4Feb 28 Declaration With- Ex-dividend Record Payment date dividend date date date date Share price falls

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 7 Dividend Payments

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 8 Stock Dividend Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? Answer 2 mil x.50 = 1 mil + 2 mil = 3 mil shares

9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 9 Stock Dividend Example - cont - After the stock dividend what is the new price per share and what is the new value of the firm? Answer  The value of the firm was 2 mil x $15 per share, or $30 mil. After the dividend the value will remain the same.  Price per share = $30 mil / 3 mil sh = $10 per sh.

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 10 Stock Repurchase Example - Cash dividend versus share repurchase

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 11 Stock Repurchase Example - Cash dividend versus share repurchase

12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 12 Stock Repurchase Example - Cash dividend versus share repurchase

13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 13 The Dividend Decision 1. Firms have longer term target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed. Lintner’s “Stylized Facts” (How Dividends are Determined)

14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 14 Dividend Policy is Irrelevant  Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 15 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record Date Cash1,000 Asset Value9,000 Total Value10,000+ New Proj NPV 2,000 # of Shares 1,000 price/share $12

16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 16 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt Date Cash1,0000 Asset Value9,0009,000 Total Value10,000+9,000 New Proj NPV 2,0002,000 # of Shares 1,0001,000 price/share $12 $11

17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 17 Dividend Policy is Irrelevant Example - Assume Rational Demiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend. Record DatePmt DatePost Pmt Cash1,00001,000 (91 sh @ $11 ) Asset Value9,0009,0009,000 Total Value10,000+9,00010,000 New Proj NPV 2,0002,000 2,000 # of Shares 1,0001,0001,091 price/share $12 $11$11 NEW SHARES ARE ISSUED

18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 18 Dividend Policy is Irrelevant Example - continued - Shareholder Value Record Stock12,000 Cash 0 Total Value12,000 Stock = 1,000 sh @ $12 = 12,000

19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 19 Dividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt Stock12,00011,000 Cash 01,000 Total Value12,00012,000 Stock = 1,000sh @ $11 = 11,000

20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 20 Dividend Policy is Irrelevant Example - continued - Shareholder Value RecordPmt Post Stock12,00011,00012,000 Cash 01,000 0 Total Value12,00012,00012,000 Stock = 1,091sh @ $115 = 12,000  Assume stockholders purchase the new issue with the cash dividend proceeds.

21. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 21 Dividends Increase Value Market Imperfections and Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from. These clients increase the price of the stock through their demand for a dividend paying stock.

22. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 22 Dividends Increase Value Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.

23. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 23 Dividends Decrease Value Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.

24. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 24 Dividends Decrease Value

25. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 16- 25 Web Resources www.earnings.com www.ex-dividend.com www.cfonews.com www.stocksplits.net Click to access web sites Internet connection required